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Is Outerwall in Need of a Diet?

Which business segment should Outerwall cut?

Outerwall(NASDAQ:OUTR) has had a crazy two months. Lowered third quarter guidance sent the stock down 22% in two days, only for it to rally all the way back to 52-week highs when activist investment firm Jana Capital Partners entered the fray with a 13.5% stake. Jana Capital believes that there is still plenty of value to be found at Outerwall, but they would like to trim the fat and create a leaner company. Outerwall's board has said that they "Welcome the opinion of its shareholders," and therefore they may sell or discontinue a part of the business, as Jana Capital desires. They have five segments to choose from:

1. Coinstar

2. Redbox

3. Redbox Instant by Verizon

4. Rubi Coffee

5. EcoAtm

Coinstar for free?Coinstar Kiosks have undergone some significant changes recently. Now, the consumer has three options for exchanging their coins, and two of them do not have a fee. First there is the classic exchange of Coins for Cash with about a 10% fee. The new fee free additions are Coins for Gift Cards and Coins for Money in your Paypal account. The addition of both the gift card and PayPal options are very smart moves. Personally the fee always deterred me, so providing alternatives has certainly swayed this Fool to be pro-Coinstar.

The will to surviveRedbox is an ingenious business. It now has over 43,600 Kiosks that provide instant gratification for New Release Movies. New Release is a critical aspect of this business because it really does hold a competitive advantage over Netflix(NASDAQ:NFLX) and Amazon (NASDAQ:AMZN) by having the newest movie content. Another plus for Redbox is that it has experienced 12.6% growth with Blu-Ray rentals, which has an edge over streaming services because of higher picture and sound quality.

This year 86% of Outerwall's revenue was from the Redbox business. Redbox's iconic kiosk video rental business has defied the market's thesis of being a doomed enterprise for several years now. That is, until Outerwall missed expectations in the second quarter and lowered guidance for the third quarter because of too many promotions and a shorter average rental time per DVD. Both are big concerns for the business, but with Q3 results hot off the press I think Outerwall may have been overly cautious.

The promotions issue appears to have been remedied now that free Red Box Instant trial subscriptions have slowed, and therefore four free kiosk rentals are not being given out so easily. It actually paid off with an increase in traffic leading to a solid finish for the quarter.

David and Goliath vs. Goliath and GoliathBillions of dollars are spent by Netflix and Amazon to obtain streaming rights for massive libraries. This simply cannot be overcome by Netflix providing a similar, but poorer, service. The group effort of Redbox Instant by Verizon has fallen well short of being viewed as a threat in the streaming marketplace.

The best part about the subscription isn't even having instant streaming, but receiving four movies for use at one of their kiosks. A more strategic approach would have been to focus on the strength of the Redbox kiosks: having the newest DVD content. Translate this focus to the streaming service and they have a niche service. Why compete with Netflix and Amazon in a game they are not willing to lose. A new plan needs to be made to produce a competitive product. Even an on-demand format that can be competitively priced works. Until then, this service will be a drain upon both Outerwall and Verizon.

New ventures: Rubi coffee and EcoATMInnovation is the driving force that will keep Outerwall a quality investment for years to come. Both Rubi coffee and EcoATM are new Kiosk products released this year, and both have a lot of potential. Rubi self-serve coffee kiosks feature Seattle's Best coffee, a Starbucks brand, and provide an instant solution to customers searching for Starbucks coffee. There are currently 280 Rubi Kiosks across the United States, with plans for expansion.

On July 1, Outerwall purchased EcoATM for $350 million. Currently, there are 800 EcoATMs which provide an automated self-serve kiosk system to purchase used mobile phones, tablets and MP3 players for cash. Customers can recycle old cell phones in exchange for cash, which is great for customers and is environmentally friendly. These two businesses are merely getting started. It is still too early to even contemplate selling or discontinuing them because the ideas are good, and both have the potential to really drive revenue growth.

Targeted weight lossJana Capital Partners has publicly stated that they are interested in selling or discontinuing certain businesses and I agree fully. Management needs to focus on what fits their business plan, "To deliver new and innovative consumer products in compact, automated formats."

I believe that Redbox Instant by Verizon does not fit their business plan, and therefore should be sold. The product is far too inferior, and it is simply not worth the money to try to compete with two companies willing to invest billions in themselves. If Outerwall can trim the fat and stay lean while focusing on the segments that work, it will continue to grow to new heights.

Rob Byrnes owns shares of Amazon.com and Outerwall. The Motley Fool recommends Amazon.com, Netflix, and Starbucks. The Motley Fool owns shares of Amazon.com, Netflix, and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Author

Robert Byrnes spends the majority of his time researching and discussing stocks. He believes that industry trends, innovation, and smart leadership are effective ways to identify strong investments for the long haul.